It is easy to understand why investors are resoundingly positive about the economic outlook this year. But are markets pricing in too much optimism?
The reopening of the US government’s spending spigots has fuelled the bullishness. President Joe Biden is pushing for a $1.9tn relief package on top of the $900bn bill passed in late December. Something in the ballpark of $1.5tn is now expected, or nearly 7 per cent of gross domestic product, according to Goldman Sachs.
Vaccine distribution is also accelerating, with the US now inoculating more than 1m people per day. The approval of the Johnson & Johnson jab could further bolster supplies, adding about 30m doses by early April and 100m by the end of June, according to Barclays.
The bank has raised its real US GDP growth forecast for 2021 to 6.3 per cent. Goldman, Morgan Stanley and NatWest Markets have recently upped their own predictions, as has research firm Oxford Economics. Its economists now expect a 5.9 per cent expansion in 2021, nearly 2 percentage points higher than their January estimate.
The reassessments have bolstered bets that Treasury yields and inflation expectations are heading higher. A sell-off in US government debt gained pace this week sending yields on 30-year bonds above 2 per cent for the first time in a year, having hovered around 1.6 per cent as recently as November. And the 10-year break-even rate, a measure of expected inflation derived from the difference between interest rates on benchmark bonds and inflation-linked debt, spiked to its highest level since 2014, at 2.2 per cent. In September, it languished below 1.7 per cent.
After such an enormous market move, “the nagging doubts begin”, says Robert Tipp, chief investment strategist at PGIM Fixed Income.
It is clear the list of credible risks is long. “It is hard not to be pretty optimistic looking out,” says David Riley, chief investment strategist at BlueBay Asset Management. But “it sounds horribly complacent, which makes me worried”.
New, more easily transmissible Covid-19 variants pose the most obvious potential threat to the recovery. Preliminary reports that show the suite of coronavirus vaccines so far approved are not as effective against the South African strain are particularly worrisome, investors say.
“The spread of the variant really is competing with the rollout of the vaccine, and that is where the risk is,” says Alicia Levine, chief strategist at BNY Mellon Investment Management.
The second issue centres around the consumer. Olumide Owolabi, a fixed-income portfolio manager at Neuberger Berman, has hinged his call for outsized growth in large part on expectations that once Americans can venture out, they will rush to spend the stockpile of savings many accumulated since the start of the pandemic. This pent-up demand will also feed into higher inflation, he says.
But what if consumers are more circumspect or the opportunities to spend are more limited than prior to the pandemic?
“We don’t really know how people are going to respond,” Riley says. “We could have a situation where we have a significant relaxation of restrictions within countries, but a tightening of travel between countries. For some [places] with big tourist sectors, that will have quite a big impact.”
If people are not spending freely by summer, Owolabi warns, the expansionary cycle he expects will be upended. “Timing is key,” he says.
The US Federal Reserve is highly sensitive to these risks, according to Tipp, who cites the central bank’s “heavy handed” reminders about the enormous ground to be made up before it will consider adjusting its policy stance.
Powell doubled down on this message on Wednesday, warning that America was “very far from a strong labour market” and that any temporary burst in inflation this year would be “neither large nor sustained”. Richmond Fed president Thomas Barkin, meanwhile, told the Financial Times this week that he sees deflationary pressures ahead.
Tipp reckons 10-year Treasury yields will slip back to 1 per cent by year end, a far cry from the 1.6 per cent or higher level some strategists have pencilled in.
“You are getting to a point where [the market] is already pricing in an unrealistic pace of Fed hikes,” he says, referencing the 2023 timeline endorsed by many investors. “The [reflation] trade is over. We are just in the overshoot, and the question is, how far is it going to go?”
Given the extraordinary support being provided by both the Biden administration and the US central bank, it could be quite a long time until reality catches up.